Bond Index Funds

In principle, bond market indexing is similar to stock market indexing. The idea is to create a portfolio that mirrors the composition of an index that measures the broad market. In the U.S. equity market, for example, the S&P 500 is the most commonly used index for stock-index funds, and these funds simply buy shares of each firm in the S&P 500 in proportion to the market value of outstanding equity. A similar strategy is used for bondindex funds, but as we shall see shortly, several modifications are required because of difficulties unique to the bond market and its indexes.

Three major indexes of the broad bond market are the Salomon Smith Barney Broad Investment Grade (BIG) index, the Lehman Brothers Aggregate Bond Index, and the Merrill Lynch Domestic Master Index. All three are market-value-weighted indexes of total returns. All three include government, corporate, mortgage-backed, and Yankee bonds in their universes. (Yankee bonds are dollar-denominated, SEC-registered bonds of foreign issuers sold in the United States.) All three indexes include only bonds with maturities greater than one year. As time passes, and the maturity of a bond falls below one year, the bond is dropped from the index. Table 16.5 presents some summary statistics pertaining to each index.

The first problem that arises in the formation of a bond index is apparent from Table 16.5. Each of these indexes includes more than 5,000 securities, making it quite difficult to purchase each security in the index in proportion to its market value. Moreover, many bonds are very thinly traded, meaning that identifying their owners and purchasing the securities at a fair market price can be difficult.

Bond-index funds also present more difficult rebalancing problems than do stock-index funds. Bonds are continually dropped from the index as their maturities fall below one year. Moreover, as new bonds are issued, they are added to the index. Therefore, in contrast to equity indexes, the securities used to compute bond indexes constantly change. As they do, the manager must update or rebalance the portfolio to ensure a close match between the composition of the portfolio and the bonds included in the index. The fact that bonds generate considerable interest income that must be reinvested further complicates the job of the index fund manager.

In practice, it is deemed infeasible to precisely replicate the broad bond indexes. Instead, a stratified sampling or cellular approach is often pursued. Figure 16.8 illustrates the idea behind the cellular approach. First, the bond market is stratified into several subclasses. Figure 16.8 shows a simple two-way breakdown by maturity and issuer; in practice, however, criteria such as the bond's coupon rate or the credit risk of the issuer also would be used to form cells. Bonds falling within each cell are then considered reasonably homogeneous. Next, the percentages of the entire universe (i.e., the bonds included in the index that is to be matched) falling within each cell are computed and reported, as we have done for a few cells in Figure 16.8. Finally, the portfolio manager establishes a bond portfolio with representation for each cell that matches the representation of that cell in the bond universe. In this way, the characteristics of the portfolio in terms of maturity, coupon rate, credit risk, industrial representation, and so on, will match the characteristics of the index, and the performance of the portfolio likewise should match the index.

PART IV Fixed-Income Securities

Table 16.5 Profile of Bond Indexes

PART IV Fixed-Income Securities

Table 16.5 Profile of Bond Indexes

Lehman

Merrill Lynch

Salomon Smith Barney

Number of issues

Over 6,500

Over 5,000

Over 5,000

Maturity of included bonds

> 1 year

> 1 year

> 1 year

Excluded issues

Junk bonds

Junk bonds

Junk bonds

Convertibles

Convertibles

Convertibles

Floating-rate bonds

Floating-rate bonds

Weighting

Market value

Market value

Market value

Reinvestment of

No

Yes (in specific

Yes (at one-month

intramonth cash flows

bond)

T-bill rate)

Daily availability

Yes

Yes

Yes

Source: Frank K. Reilly, G. Wenchi Kao, and David J. Wright, "Alternative Bond Market Indexes," Financial Analysts Journal (May-June 1992), pp. 44-58.

Source: Frank K. Reilly, G. Wenchi Kao, and David J. Wright, "Alternative Bond Market Indexes," Financial Analysts Journal (May-June 1992), pp. 44-58.

Figure 16.8 Stratification of bonds into cells.

Sector

Term to maturity

Treasury

Agency

Mortgage-Backed

Industrial

Finance

Utility

Yankee

<1 year

12.1%

1-3 years

5.4%

3-5 years

4.1%

5-7 years

7-10 years

0.1%

10-15 years

15-30 years

9.2%

3.4%

30+ years

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

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